How Much to Pay Yourself and How

Paying yourself last is a strategy to get by, not a strategy for success.

Many small business owners end up paying themselves by what’s left over at the end of the month after other expenses are paid. That way, you often end up with a big swing in your monthly take home pay, with some months being very lean and some months being fat. This may work for a young single person with a more flexible lifestyle, but doesn’t work so well for the small business owner who has a family and a mortgage who needs more stability.
Besides, you started a business to make a good living, right?

Start with a plan
Everyone who knows me knows that I coach every business owner to create an annual profit plan or budget. Why is this so important? Creating a detailed annual plan that shows your projected income and expenses for each month helps you to see if what you are setting out to accomplish is reasonable to achieve, and if it will produce the results (profit and cash flow), that you need to compensate yourself appropriately, and invest in growing your company.

What’s an appropriate amount for owner compensation?
First, it starts with your needed and desired personal income. Do your personal financial planning and budgeting, so you’ll know what you need each month to provide for your personal lifestyle. Beyond your normal monthly needs, you may also have a desired income amount that you’d prefer to bring in from the business for investments, travel, etc. It’s important to know these numbers and to factor them into your budget/profit plan for the year.
Not every similarly sized business will have the same number. Your personal financial needs and desired income are your own. One business owner with a $600,000 business may be satisfied with $90,000 in compensation, while another needs $200,000. The business model and structure, not to mention future vision, may look very different for these two individuals.
Make a plan to pay yourself at least the necessary amount to meet your monthly personal income needs each month. Just like you pay your employees on a regular basis for their services to the company, you need to pay yourself. Then you can plan to pay yourself extra amounts in your most profitable months to make up the difference between your necessary income and your desired income.

Best Practices
I have a metric that I like to use called Net Operating Profit before Owner’s Compensation. I believe that 20-25% is a good result for most contracting businesses between $300,000 and $3,000,000 in revenue.
Out of this profit comes the owner’s compensation. In the middle of this revenue range, about 15% – 20% of revenue is reasonable for owner compensation. For example, at $1,000,000 in revenue, this would amount to $150,000 – $200,000 in owner’s compensation. A higher percentage is needed for the lowest revenue range to produce an adequate living compensation, and a lower percentage is needed for the higher end of the range since there is a larger need for bigger companies to invest in growth and infrastructure while still compensating the owner well for his or her investment in the business.

Methods for paying yourself
There are different requirements for how to take owner’s compensation from your business depending on what your legal entity is. It is a good idea to consult with your business attorney and tax advisor to understand the tax laws regarding how you take compensation, and to make the best decision for you.
Typically, if your company is an S-Corporation, you need to take a “reasonable” salary as a W-2 employee and then take the balance of your compensation in draws or distributions, while LLCs and Sole Proprietors usually take their entire compensation as a draw. There are tax ramifications for each, so be sure to consult with your CPA.

The real bottom line is that you started a business to create a better life for yourself, and usually that better life includes a comfortable level of compensation that enables you to live the lifestyle you desire and to provide for your retirement. Achieving this takes vision, planning and implementation of your strategy to grow a profitable and successful business, however you define success.